The “Short-Termism” Critique of Public Companies Is Nonsense

New research finds that publicly traded businesses are much more likely to invest in physical capital and R&D than privately held firms

By

Matthew C. Klein

Oct. 4, 2018 11:39 a.m. ET

The public company is one of the greatest financial innovations of all time. Businesses sell shares of future profits to savers and can use the money they raise to fund additional investment, repay earlier investors, and reward employees. As those shares get traded by professionals, price changes can guide managers on capital spending, aid in employee recruitment, and make it easier to do mergers and acquisitions.

Unlike debt, equity financing is permanent capital that can flexibly respond to changes in business conditions....

The public company is one of the greatest financial innovations of all time. Businesses sell shares of future profits to savers and can use the money they raise to fund additional investment, repay earlier investors, and reward employees. As those shares get traded by professionals, price changes can guide managers on capital spending, aid in employee recruitment, and make it easier to do mergers and acquisitions.

Unlike debt, equity financing is permanent capital that can flexibly respond to changes in business conditions. It is no coincidence that the most prosperous and creative societies use the stock market more than bank loans to fund their enterprises.

Yet many nevertheless argue the public markets are bad. A surprisingly broad coalition claims that “short-termism” is a disease caused by frequent public disclosures, accountable managers, and activist shareholders.

Stock markets, in this view, make managers myopic and unwilling to do transformative investments. Some think that replacing public shareholders with “patient capitalists” such as private equity, family-owned businesses, and other forms of concentrated ownership will supposedly make things better. Others want to force public companies to put workers and suppliers on their boards in the hope that they become more concerned with the “long term.”

New research from a team of economists from the Federal Reserve, the University of Michigan, the University of Utah, the U.S. Treasury, and JPMorgan decisively refutes these arguments. Companies with publicly traded shares invest proportionately far more than privately held businesses. The difference is particularly stark when comparing spending on research and development. America’s publicly traded companies account for only 30% of total sales by businesses in the U.S. but are responsible for 45% of all capital investment and fully 60% of total R&D.

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“Despite the earnings pressures that public firms may face, access to capital markets appears to make public firms particularly successful at financing riskier R&D investments,” the economists write.

Moreover, the data show that the same businesses behave differently depending on their ownership structure. Companies significantly increase their investment in R&D after they have gone public compared with when they were private, while companies that delist dramatically reduce their capital expenditure and research spending compared with when their shares were publicly traded.

Previous studies often found that private companies did better than public ones on certain measures, such as patent productivity, but those were flawed because they were not able to analyze a representative sample of private companies. After all, the reason that private firms are supposedly able to take a “longer term” perspective is because they are not transparent.

One way to get a comprehensive view of their activities is to look at tax data. Conveniently, these data are comparable across different types of companies regardless of their ownership structure. Among other things, the Internal Revenue Service tracks sales, profits, assets, and interest payments. Investment spending can be tracked by looking at R&D tax credits and depreciation allowances.

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The data also allow the economists to filter out extremely large and extremely small companies that could distort the sample. They focused only on businesses with assets greater than $1 million but less than $1 billion, and with sales greater than $500,000 but less than $1.5 billion. They also excluded real estate investment trusts and regulated investment companies, but otherwise included all nonfinancial C and S corporations.

Finally, they created apples-to-apples comparisons by making sure that their samples of public and private companies had similar industry mixes and size distributions, based on sales. They studied data from 2004 through 2015, a period that did not feature meaningful changes in corporate tax policy.

Perhaps the most interesting finding is that public companies invest much more than private companies even when stock markets seem to encourage “short-termism.” The economists looked at how much each public company’s stock price moved in response to earnings announcements to track their sensitivity to activist pressure. Consistent with previous studies, they find that “short-term performance pressures reduce investments in these assets that depreciate slowly or may take time to generate returns.”

However, they write, “these reductions in long-term investments and R&D are not large enough to overcome the baseline investment advantage of public firms.” In fact, “greater responsiveness to market pressures is related to public firms investing even more than their private counterparts” when excluding R&D.

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Their conclusion is that “if the U.S. wants more investment and especially innovation investment, it wants more public firms.” Unfortunately, the trend seems to be going in the other direction.

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